Description

Summary:

We believe MOVI is a good short opportunity. MOVI has a bleak future and is a over levered, debt stricken company, one in a dying industry. With a PE of 8x’s 2006 eps, it is a classic value trap. The E in the p/e could dissipate completely caused by a large debt burden, additional combination cost related acquisition of Hollywood Video, and shrinking sales. MOVI is unlikely to produce $300m ebitda in 2006. MOVI needs a minimum of $350 EBITDA to remain compliant with its debt covenants. ALL stores and even corporate Headquarters are leased so there is substantially more leverage than appears upon cursory review.

MOVI management remains committed to adding new stores in a dying industry. Management is operating on the premise that recent industry weakness is chiefly product-related (meaning not enough blockbuster titles have hit the selves lately on a YOY basis). My recent conversation with MOVI’s investor relations, spoke of building out 300 stores this year and at least 150 in 2006. In light of the continued decline in the “in-store rental business”, The stock is overvalued with a weak FCF yield over the EV of less than 2% , which is certainly inadequate for the amount of risk incurred.

Finally, its probable that video rental is to become the “BetaMax” of 1980’s; and as a result of recent Hollywood video acquisition the company is a Debt DOG (1), and a restructuring is looming. Debt covenants – i.e. ebitda ratio requirements have already fallen from 4.0 to 3.5, and are planned to drop to 2.5 by the end of 2006; MOVI will need over $350m in EBITDA to curtail restructuring.


Company description:

Movie Gallery, Inc. operates home video retail stores that rent and sell movies and video games in North America. The company rents and sells digital versatile disks, videocassettes, and video games. In April 2005, Movie Gallery acquired number two operator Hollywood Entertainment for $1.1B in cash and assumed debt (excluding operating lease liabilities), making inroads into urban and more crowded markets. Additionally, the Hollywood acquisition gave the company increased west coast representation. The overwhelming majority of Hollywood store are in locations that that compete with Blockbuster stores, while only about 30% of the legacy Movie Gallery stores are in locations that compete with Blockbuster. From a single store in Portland, Oregon, Hollywood Entertainment has grown to become an industry leader with more than 2,000 Hollywood Video superstores and more than 700 Game Crazy specialty retail outlets nationwide. Growth continued when Hollywood Entertainment was acquired by Movie Gallery, Inc., creating a combined organization of more than 4,500 stores serving urban, suburban and rural markets. Movie Gallery was co-founded by J. T. Malugen and H. Harrison Parrish in 1985. The company is headquartered in Dothan, Alabama.

Valuation:
The ‘base case’ for 2006: $200 ebitda), base case to the EPS at $.60; so about 8x’s 2006 p/e. However ebitda could be much worse depending on how poorly the acquisition integrations fares, and the extent of year over year declining sales.

So for 2006:
Ebitda: $200m
NI: $20m
D&A: $100m
CapX: $100m
FCF: $20m
Interest payments in 2006: $103m ($25m+ payment per quarter)
Market Cap: 32.5m shares outstanding, and price at at $5.5 pershare = $180m
Net Debt: $1.15B (avg interest rate: 9%)

FCF (after all CapX) for 2006 in my model is $20m, so the range of FCF yield over the current market cap of (32.5m shares at $5.5) $180m market cap is 11% fcf yield over the market cap; but more relevant is the FCF yield over the EV. The range of FCF yield over the FCF / EV is 1.56%.

As a Perma-Bear on MOVI, I am different from Wall Street’s consensus, in that im modeling a relatively fixed store operating costs, and so the magnitude of the impact on earnings from future same-store sales declines is staggering. It’s the high fixed cost retail conundrum; increasing sales are the utmost important factor. Nothing seems to work when the organic or same store sales are declining; especially for financial models.

Catalyst:

By 3Q06, MOVI should fall short of its required debt covenant ratio obligation of 3.5x’s EBITDA. Currently for remainder of 2005, the coverage ratio is set at an easier 4x’s but is planned to be dropped to a more difficult to meet 3.5x’s. The debt holders will then have the ability to restructure the company in attempt to regain a portion of their $1b+. MOVI’s Net debt of $1.1B has an average interest rate of 9%. I believe the probability of MOVI violating the current banking covenants is very high. I think they the debt holders will likely gain control of the business (away from somewhat confused management) and milk the cash and potentially come up with a better idea for the retail square footage than selling the “BetaMax” or last generations’ technology in a dwindling if not dying industry/sector.

In this case restructuring or re-capitalization will likely occur, which results in either massive dilution or bankruptcy. MOVI meets every criteria for a distressed situation: high ratio of debt to assets, low interest coverage, declining profit margins and cash flow problems, upcoming scheduled debt repayments. Further facts, MOVI’s sharply declining fundamentals; Ready for a Run-On sentence: EBITDA in the 1st half of 2005 declined 7.5% YOY, Free cash flow has turned negative from $117 million (proforma) in Negative sames-store rental revenue is the serious problem – down 8.4% in Q2 ’05 (even worse than Blockbuster’s Q2 rental comp of neg 6.6%.), declines in same-store revenue produce an even more dramiatically negative impact on profitablity because video rental stores have high fixed cost., and finally Q2’05 net income was negative in spite of only two months of interest expsense (hollywood acquisition closed 4/27/05). Recent relevant historical dates: On Sep. 15 – announced that its Q3 comps will decline 9-10%, and that q$ comps will decline 8-10%. On Sep 23 – amended debt covenants, from an original maximum leverage ratio (Net Debt to TTM EBITDA) of 3.40 to a new max of 4.0. Within only two months after closing the deal to acquire Hollywood, Movie Gallery was already in violiations of its covenants, with a leverage ratio as of 6/30/05 at approximately 3.66. On Sept. 26 - suspended quarterly dividend, after having only paid dividend for six quarters (a cumulative total of $0.18 per share).

The acquisition of Hollywood video came at the worst possible time – just as the industry/sector hit a Tipping point – sales off 8% yoy. This acquisition has saddled Movie Gallery with over $1.1B in debt – of which $820m at variable rates (9%) in a rising interest rate environment. Movie Gallery has already amended its credit facility once, with higher interest rate costs as a result (the 1st amendment to the debt has already needed to be renegotiated with in 6 months of deal completion!). Overall, we estimate Movie Gallery will incur $103m in interest expense in 2006, well above the $50m in cost saving that Movie Gallery claims/aims to wring out of the combined business by 2007.

S&P lowered its MOVI bond ratings to CCC on November 11th, down from CCC+, on weakness in the industry and little expected near-term improvement. It left the Outlook Negative, implying further downgrades are possible if the environment deteriorates or if liquidity becomes tighter. Moody’s still has the credit rated B3, also with a Negative Outlook. A Moody’s downgrade is likely within the next 6 months, bringing the credit firmly into CCC territory. [SIDENOTE: another near term negative catalyst].

The Bull case:

Some believe MOVI can/should obtain covenant relief when the time comes, and avoid bankruptcy. There current 2006 estimates presume that MOVI is in violation of its revised leverage ratio covenant but its plausible that Movie, like Blockbuster, would be able to obtain additional covenant waivers from its banks, especially if sales trends begin to stabilize, as expected. The Bull also believes (notice bull; I have located and had discussions with only 1 bull not multiple “Bulls”) the company could top covenant requirements with asset divestures. The company has proposed potentially divesting its Game Crazy business, which at .4x CY05 sales would value it at about $100m (GameStop, a comparable is currently valued by the market at .5x’s revenues, but its profitable). The combination of improved Ebitda and cash proceeds from divesting this unit would put the company in compliance with its 3Q06 covenants. [SIDENOTE: the Game Crazy business should lose $6.0 EBITDA in 2005, so not sure that $100m is fair value. ]

MOVI currently has adequate liquidity (for the next 2 quarters), but maintaining that liquidity WILL depend on the bank’s willingness to further renegotiate covenants (unless sales and results improve considerably from here).

One retail credit analyst at JP Morgan believes that the company could violate a covenant as early as second quarter of 2006, but more likely in fourth quarter, when the leverage covenant steps down to 2.5x, implying the company must generate EBITDA in the $400m range. The JP Morgan credit analyst (the Bull) believes the company must generate between $250 and $260 million of EBITDA for 2005 to remain in compliance with covenants, which she believe is achievable. However, for 2006, the leverage covenant steps back down to 2.5x by year-end, in which case, she believes the company has to generate over $350 million of EBITDA to remain in compliance. This will be more challenging, in her opinion.

MOVI showed that it had access to the loan market on September 23rd when the company received an additional $50 million of term loan financing in order to fund working capital (related to the new Xbox 360 release in November) and to purchase of 20 stores from former Hollywood CEO, Mark Wattles. At the same time, the banks amended covenants, raising the net debt/EBITDA covenant to 4x for the remainder of 2005 and 3.5x for the first three quarters of 2006.

If/when MOVI comes under pressure from the banks, it could reduce capital expenditures to a maintenance level of about $50 million (this would maintain existing stores, but allow for no new builds). With interest expense totaling about $100 million, the company only needs to generate $150 million of EBITDA to be breakeven.



MOVE Gallery Simple Free Cash Flow
$ in millions
CF Breakeven
EBITDA 150
Interest (100)
Maint Capex (50)
Free Cash Flow 0

Debt 1,170
FCF/Debt 0.0%


Competition and Final thoughts:

Today’s movie buffs , i.e., Movie gallery’s best customers are opting out of video rental stores and choosing one of three alternatives: subscribe to an online DVD rental plan, such as that offered by netflix ( ~75% market share) which offers unlimited DVD’s for as little as $9.99 per month), purchase DVDs from low-cost outlets like WalMart or Amazon at prices of $15 to $20 per DVD to build a home movie library, or third steel the movies – i.e. via a friend’s collection – simply BURN them or download them from the computer.

Movie Gallery can’t compete Wal-Mart’s low pricing on new DVD’s, and it can’t compete with Netflix because Movie Gallery doesn’t even offer an online rental plan. As movie gallery continues to lose customers to these alternatives, its same-store rental revenues will continue to decline, pushing it deeper into the red.

Currently lossened debt covenants are set to re-tighten as of q3 ’06 – from the current max leverage ratio of 4.0, back down to a max of 3.0 (then eventually 2.5x’s coverage by the end of 2006).

Barring a miraculious return to positive rent comps, MOVI will post losses each quarter and will have no chance of reducing its leverage ratio.

Why did CEO/Founder – Malugen do this acquisition, outbidding Blockbuster by 20%.?

Buying sales(acquisition growth CapX) at the detriment to profits is a foolish long-term strategy.

Catalyst

By 3Q06, MOVI should fall short of its required debt covenant ratio obligation of 3.5x’s EBITDA. Currently for remainder of 2005, the coverage ratio is set at an easier 4x’s but is planned to be dropped to a more difficult to meet 3.5x’s. The debt holders will then have the ability to restructure the company in attempt to regain a portion of their $1b+. MOVI’s Net debt of $1.1B has an average interest rate of 9%. I believe the probability of MOVI violating the current banking covenants is very high. I think they the debt holders will likely gain control of the business (away from somewhat confused management) and milk the cash and potentially come up with a better idea for the retail square footage than selling the “BetaMax” or last generations’ technology in a dwindling if not dying industry/sector.